Frost

Consulting

Introduction to Global Commission Unbundling

Market Structure Change: Upending the Status Quo
Risks and Rewards

July 2012

Frost
Consulting

How do the economics of the institutional equity market work?

Equity Commissions

Frost
Consulting

The Currency of the Institutional Equity Business

Equity commissions are attached to every trade to pay for services.

Equity Trade
Broker

Asset Manager #1

Exchange

Equity Order:
BUY 1 Million IBM
Shares
Purchased

Cash for Equity Trade

Asset Manager #1

Broker

Asset Manager #2

Broker

(Seller of Shares)

Equity Commissions

How big is this market?

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Frost
Consulting

Institutional Secondary Equity Commissions

2011e: $33 Billion
Most equity commissions are split into 2 components:
Non-Execution

Execution
Pays for the physical cost
of trading and clearing the
transaction.

33%
$ 10.9 Bln

67%
$ 22.1 Bln

Pays for all non-execution

services including:
Investment Research

Key Point: Commissions belong to the asset managers client not the asset manager.
But, the asset manager decides where and how to spend them.
* Frost Consulting Estimates

Frost
Consulting

The Bundled Commission Environment

Key Points:

Asset managers use commissions to buy goods and services, because its not their money. It belongs to their
asset owner clients. (Pension Funds/Mutual Funds)

Consequently, the majority of research purchased by asset managers (~$20 billion per annum) is bought via
commissions.

In the bundled commission environment, the 2 commission components (execution and non-execution) are
inseparable and are captured by the broker executing the equity trade.

Therefore, the only way for asset managers to buy research (and related services) using their clients money, was
to buy them from companies with an equity execution capability (investment banks/brokers).

It was the act of equity execution which generated the commissions which could be used to buy goods and
services.

This meant that investment banks/brokers had a very high market share of asset manager research spending.

For the last 30 years most asset managers have bought research from fewer than 100 investment banks. Even
though thousands of other types of research producers generate information that could aid asset manager
investment decisions, these could only be purchased with the asset managers own funds, rather than with their
clients money.

Frost
Consulting

Regulatory Evolution

2003 FSA (CP-176) Commission Unbundling

(Unbundling mandatory for UK asset managers)

2006 SEC creates similar CCA structure.

2007 MiFID indirectly supports CSAs via Best X Requirements

2010 ERISA : Research Spending Reporting Requirement

(Dept. of Labor requires US pension funds and their underlying asset managers
to justify research spending - CSAs will be central to this process.)

Frost
Consulting

Commission Unbundling:
Significant Implications for All Market Participants

Regulatory changes (Commission Sharing Agreements: CSAs) now allow asset managers to unbundle or split their
brokerage commissions between the execution and the non-execution components. The execution portion goes to
the broker executing the trade. The non-execution portion goes into a separate account.

The accumulated funds in the separate account can be used to buy research from any type of research producer
(not just brokers), just like a regular bank checking/current account.

The de-regulation of commissions means that the asset managers content universe is now virtually limitless
because they can use commissions to buy new sources of research without having to pay for it via an additional
equity execution relationship. As a result, forward-looking asset managers are rapidly adding research sources and
reducing the number of equity execution relationships.

This ends the 35 year-old oligopoly of investment banks over asset manager research spending.

Asset owners, asset managers and investment banks will have to adjust their strategies to maximize returns in this
new regulatory environment.

CSAs: Asset Manager View

Frost
Consulting

Exploding the Asset Manager Content Universe

Client CSA Account

Asset Manager

Implications

(Held by CSA Broker)

Historic Inputs

New Inputs

Typical Trade
Research
Commission 8 Bps

$22
Billion
Globally

$22
Billion
Globally

$21.4 Bln

Rewards/Risks for Asset Managers:

$9.1 Bln

CSA Execution
Broker
Execution
Commission 4 Bps

$11
Billion
Globally
$11
Billion
Globally

* Frost Consulting Estimates

Historic ~100% market share going

in one direction down. This will
prompt investment banks to cut
research budgets further.

Opportunity to generate more alpha

from widened content universe.
Many will have to revamp research
procurement process to take
advantage.
Asset managers that do not unbundle
and widen research universe will be
at a competitive disadvantage in an
increasingly global marketplace.
Plan Sponsors:
Must develop new ways to measure
the risk/reward of their managers
research procurement processes.
Content Producers:
Large opportunity to access $20
billion in annual asset manager
research spend.
Challenge to circumvent asset
manager content firewalls.

Frost
Consulting

Asset Owner Challenge:

Are Asset Managers Leveraging Market Structure Change?

Bundled
Research Universe

Unbundled Research Universe

Declining Research
Budgets

~4,600

Most asset managers buy research

from < 100 investment banks.

Losers

This is the new battleground for

differentiated asset manager alpha.

Proprietary Research
Network

Winners

Question for Pension Funds: Where are your asset managers on this spectrum?

Frost
Consulting

Global Institutional Equity Business

Information Explosion

Asset Management Overview

Investment Banking Research

8,000 Institutional Equity managers.

~750 conventional equity brokerage firms.

$30 trillion in assets under management.

~$5 billion in sell-side research budgets per

annum.

$200 billion in asset management fees

per annum.
>$20 billion spent on the purchase of
equity research per annum.

3,000 publishing analysts producing ~300,000

documents per annum.

Non Investment Banking Research

Economic, industry, strategy consultants, expert
networks, academics, industry journals.
~30,000 producers (English Language)
producing ~2 million documents per annum.

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Consulting

Global CSAs:
Penetration Rates
Operational Challenges
Increasing Regulatory Scrutiny

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Frost
Consulting

Unbundled Commissions: Regional Penetration

Percentage of Total Volume Traded

UK

70%

Europe (Ex-UK)

50%

US

40%

CSAs are growing rapidly as asset owners, asset managers and regulators recognize their benefits.

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Frost
Consulting

Reporting Transparency
Challenges for Asset Owners/Managers to Meet ERISA Requirements
Harnessing Big Data
CSA Required
Services
Market
Required
CSA Services
CSAs:
Services

Global CSA Annual Market Metrics

(2011e)

Questions for Pension Funds:

Face Value CSA Equity Trades

Number of One Sided Transactions
Distributable CSA Commissions
3rd Party CSA Payments
Number of Discrete Bilateral CSAs

~$10 Trillion

Matching

1.0 Billion

Reconciliation

$6.6 Billion

Custodial Services

$3.3 Billion
11,200

Payment Services

Is there one person or

group with oversight
responsibility for the
entire process?

Contractual Services

3rd Party CSA Recipients

~135,000

Messaging

Annual Number of Payments

~530,000

Audit Trail

Estimated 5 Year CAGR: 20%

Who is performing/
monitoring these
tasks at the underlying
asset manager?

Does your fund demand

commission allocation
transparency?

Up to $800 million per annum may be unintentionally left with CSA execution
brokers though sub-optimal asset manager commission allocation practices.

Estimates: Frost Consulting

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Frost
Consulting

Regulatory Scrutiny

ERISA New Reporting Regulations

From July 2010 all ERISA funds will have to report annually to the Department of Labor
A) All counter-parties paid more than $5,000. This includes brokerage commissions paid
by their underlying asset managers for research.
B) The fund, via the asset manager, will have to value the research purchased to ensure
that the cost was reasonable.

This is a material change in the level of regulatory scrutiny applied to non-execution commissions. Failure to
Monitor Plan Expenses is a frequent complaint in ERISA class-action lawsuits. Brokerage commissions are
Plan Expenses.

Most asset managers investment processes are not designed to deal with this new regulatory regime.

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Frost
Consulting

Ongoing ERISA Class Action Investigations (62)

Including:
Enforcement
The most effective agent of
compliance is not the Department
of Labor. Class action lawyers get
a portion of the ERISA class
action settlement fee and are
therefore far more motivated than
regulators to pursue cases in
which there is insufficient
transparency in the institutional
research commission allocation
process. ($20 billion per annum).

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Frost
Consulting

Conclusion

Commission unbundling offers both opportunity and risk to most market participants.

Plan Sponsors

face performance risk/opportunity depending upon the effectiveness with which underlying
asset managers address market structure change for research procurement.
- face regulatory risks relating to ERISA reporting requirements.

Asset Managers

face performance (and commercial viability) risks depending upon the effectiveness
with which they address market structure change for research procurement.
- face client and regulatory risks relating to the more complex CSA payment environment.

Investment Banks face challenges adjusting their cost bases to a reduced revenue streams as they lose market
share in asset manager research spending.
- risk being disintermediated (paid via CSA from other banks rather than via execution). If they
fail to offer competitive CSA execution products they risk irrelevance in the execution market.

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Frost
Consulting

Additional information/analysis at:

www.frostconsulting.co.uk

For more information please contact:

Neil Scarth
UK cell +(44) 774 865 2356
neil.scarth@frostconsulting.co.uk
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